BNP's Spectrum-linked momentum notes feature volatility control feature; Lehman plans Aussie bull notes

By Kenneth Lim

Boston, June 4 - BNP Paribas's principal protected notes linked to its long/short index can afford to offer a generous participation rate because of a volatility control mechanism in the underlying, a market source said.

Meanwhile, Lehman Brothers Holdings Inc. announced a series of notes that are bullish on the seldom-seen Australian economy.

BNP ties to long/short index

BNP is offering a series of zero-coupon notes due June 30, 2011 linked to its Spectrum Long/Short Style Excess Return index.

At maturity, the notes will pay par of $1,000 plus 90% to 110% of any gain in the index. If the index finishes below its initial level, investors will receive par. The participation rate will be determined at pricing.

The underlying index is an equity index whose level depends on the performance and long/short pairing of eight total return equity indexes. The indexes are the S&P 500/Citigroup Growth Total Return, Dow Jones U.S. Select Dividend Total Return, S&P 500 Total Return, DJ Euro Stoxx Large Cap Growth Total Return, DJ Euro Stoxx Large Cap Value Total Return, DJ Euro Stoxx Select Dividend 30 Total Return and DJ Euro Stoxx 50 Total Return.

The rules-based index is assessed daily. The index allocation has two steps. The first step selects long/short pairs among the indexes in each of the U.S. and Eurozone geographic areas, while the second step determines the weight of each long/short pair to achieve a target volatility of 8%.

"Fundamentally, the underlying index follows an innovative style allocation approach by applying a nondiscretionary methodology of momentum investing to the index components, which represent four different investment styles (growth, value, dividend payers and market)... across two different geographic regions (the United States and the Eurozone)," BNP said in a prospectus.

"A momentum investing strategy seeks to profit from an existing trend in the market based on the belief that once a market trend has been established, it is more likely that market movements will continue in that direction than shift against the market trend."

Index rides momentum

The index is based on the belief that certain investment trends in the equity markets persist for some time, said a person familiar with the index.

"Markets exhibit certain trends, and momentum in the markets often persist for a long period of time," the source said. "The purpose of this index is to capture those trends and to ride them out as long as possible, and when they burst, to capture the next trend."

"It is designed to identify fundamental market trends, establish market neutral long/short positions and ride out the trends as long as they continue," the source added. "When the index detects new fundamental trends taking place, the old positions are terminated and new ones are established."

Volatility control helps pricing

The source said the index has an unusual feature that allows it to reduce uncertainties about volatility.

"It's an embedded risk control measure within the index itself," the source said. "There are two benefits to this. One is you get returns that could be compared to hedge fund returns because it's got low volatility underlying. The second, and probably the more important benefit, is that because it's got a target volatility, people hedging it can be very aggressive in pricing. If you are offering options linked to the S&P 500, traders today don't know what the volatility is, so they have to price in a discount. But because the volatility is controlled...you are able to offer types of products linked to this index that you wouldn't be able to offer with other indexes.

"Like in this case, the three-year principal protected note linked to this index has a participation rate of 90% to 110%, whereas if you were to offer a principal protected product linked to the S&P, the participation rate would probably be less than 50%."

The source said the product could be attractive to retail and high net worth clients, who typically prefer shorter dated structures of two, three or five years. Institutional investors could also be interested in the same structure, but possibly with longer tenors.

Based on hypothetical historical data, the index, which was launched in June 2007, would have had a 9.5% growth every year over the past 10 years. The index tends to do better when an investment trend is strong, the source said.

"The index is really designed to capture long term trends, so it does better when you're in the middle of a trend," the source said. "It probably will not do necessarily as good when the fundamental trends are churning around. Historically we've seen that these longer fundamental trends have dominated over a long period of time, so in those periods when the index identifies those trends and rides them out as long as possible, it does better. When the trends change and the new trends are being established, it probably will not do as well."

Lehman ties to Australia

Lehman plans to price zero-coupon 100% principal-protected Aussie bull notes due June 27, 2012 linked to an index, currency and commodity basket.

The basket consists of the S&P/ASX 200 Index with a 33.34% weight, the spot rate of the Australian dollar against the U.S. dollar with a 33.34% weight, high grade primary aluminum with a 16.66% weight and copper - grade A with a 16.66% weight.

The payout at maturity will be par plus any gain on the basket. Investors will receive at least par.

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